Saturday, August 18, 2012

How Much Working Capital Do You Need?

When the bank asks why you need that high of a limit on your line of credit, or when you want to do a little scenario planning to make sure you'll have enough resources to handle growth, I recommend you turn to a ratio called Days Working Capital (DWC).

Here is what you'll need:
  • Accurate balance sheets for the past couple of years. These need to be prepared on an accrual basis.
  • Validated assumptions about how your growth or shrinkage impacts changes in all of your current assets and current liabilities. This includes accounts receivable, inventory, accounts payable, prepaid assets, short-term debt, deferred revenue, etc.
  • Validated assumptions on your revenue and profit/loss for the forecasted period.
  • Forecasted capital expenditures (CAPEX) and other investments for the period.
Now, let's jump into the seven steps to know how much working capital you need.

1. Calculate DWC historically.
The formula is actually quite simple. Multiply your working capital (from your balance sheet subtract your current liabilities from your current assets to find your working capital) by 365 days, then divide that total by your annual sales revenue.

Average Working Capital x 365
Annual Sales Revenue

Do this for the last 24 months, making sure to annualize sales revenue. The result is a decent historical range of your DWC. It might look something like this:

2. Benchmark your DWC to others in your industry.
Once you understand how your DWC has worked for the last two years, compare your findings with industry averages. DWC is not commonly published, so you'll likely need to apply the same formula to the financial information available for your industry and competitors.

3. Determine an acceptable range within which your DWC may fluctuate given your best and worst case scenario projections (OPTIONAL BUT RECOMMENDED).
To be done as accurately as possible, this next part requires the use of a financial model for your business, complete with full balance sheet modeling. If you do not have that, then you can merely estimate based on your industry averages and your own historical performance. Based on the chart above, your have experienced a 2-year low DWC of 36 and a 2-year high of 62.

If you do have a financial model, plug in your best and worst case scenarios in terms of growth, slower/quicker customer payments, and "sticky"/lean inventory. Then you can use the low and high scenarios from what you think will actually happen, whereas you will be handicapped by the assumption that nothing material in terms of your working capital cycle will change if you are only able to use historical information.

4. Subtract net CAPEX (add back any financing used for the CAPEX) and planned investments from today's working capital balance.
Next you need to analyze any future draws on working capital outside of your normal operations (for purposes of this post, I will assume our analysis will just comprise the next 12 months). This will include a subtraction of working capital funds used to fund CAPEX and other investments during the next 12 months. Your calculation should look something like this:

Working Capital Balance Today
     minus CAPEX not financed, or net CAPEX
     minus other investments
Working Capital available for next twelve months

5. Add anticipated profit margin or subtract anticipated losses during the period to your working capital balance today.
Whether or not your business is earning or losing money will have an impact on working capital as well. For the coming 12 months, either add your estimated profits or subtract your estimated losses to derive your estimated working capital available for the next 12 months. For this post, we will assume this equals $500,000.

6. Reverse the DWC formula to solve for working capital.
The next part is my favorite. By using a little algebra we reverse the forumla to solve for total working capital required, meaning the amount of working capital we think we might need during the next 12 months given our various scenarios. Here is what the formula looks like:

DWC x Annual Sales Revenue

For illustration purposes, let's suppose my annual sales revenue is projected to be $5,000,000. With a DWC as low as 36, my working capital required would only be about $493,000. If my DWC grew to 62, then I would need working capital of about $850,000.

7. Subtract your estimated working capital available the period from your various working capital required scenarios to determine your cash need or excess.
In the lowest working capital scenario, you would not need any additional cash during the next 12 months. ($493,000 - $500,000 = -$7,000). This seems to be cutting it pretty close. If your growth is concentrated in just a couple of months, you have some key customers take a little longer than usual to pay, or you have any other negative hits to your working capital, you likely will need more cash. In our highest required working capital scenario, we could need as much as $350,000 ($850,000 - $500,000 = $350,000). Since this analysis only looked at the high and low examples, it is very likely that the cash needs for your business during the next twelve months will fluctuate somewhere in-between.

Besides just using a single variable of DWC to run various scenarios, you may also want to run a few scenarios at different sales revenue levels and make appropriate adjustments to the rest of your assumptions as appropriate. Once you are done, you'll be able to clearly and confidently articulate exactly how much additional cash flow, if any, you need to keep your business properly capitalized.